Opinion
Case No. 98-15257-SSM, Adversary Proceeding No. 99-1074
February 2, 2000
Thomas F. DeCaro, Jr., Esquire, Upper Marlboro, MD, of Counsel for the plaintiff
James J. Wilkinson, Esquire, Washington, D.C., of Counsel for the defendant
MEMORANDUM OPINION
This action is before the court on cross motions for summary judgment filed by the plaintiff, Eugene Leedy ("the debtor"), and the defendant, the United States of America. A hearing was held on November 23, 1999, at which both parties were present by counsel. At issue is whether the debtor properly claimed certain business-related expenses as deductions on his personal income tax returns for 1991 and 1992. The United States, on behalf of the Internal Revenue Service ("IRS"), asserts that the deductions could be taken only by two corporations owned by the debtor, and not by the debtor personally. The court took the matter under advisement at the conclusion of the hearing in order to review the applicable law.
The court has been advised that the debtor died subsequent to the hearing. The death of a chapter 13 debtor does not necessarily require dismissal of the case "if further administration is possible and in the best interest of the parties." F.R.Bankr.P. 1016. Since the debtor's chapter 13 plan was being funded from his earnings as a consultant, further administration is probably not possible, but that issue is better addressed in connection with any motion that may be brought for dismissal of the case. With respect to the present adversary proceeding, Rule 25(a)(1), Fed.R.Civ.P., which is incorporated by F.R.Bankr.P. 7025, requires that a motion to substitute "the proper parties" for a deceased party must be made within 90 days after the death is suggested on the record. In this instance, the "proper party" would be the executor or administrator of the debtor's estate, if one is appointed.
Background
On July 14, 1998, the debtor filed a voluntary petition for bankruptcy under chapter 13 of the Bankruptcy Code in this court. After many months of litigation and negotiation, a plan was ultimately confirmed on August 16, 1999. The plan requires the debtor to pay to the chapter 13 trustee $1,708.43 per month for the first 7 months, then $3,236.49 per month for 5 months, and then $3,483.00 per month for the remaining 48 months. From those funds the trustee is to pay his own statutory commission, $8,498.84 in priority taxes to the Virginia Department of Taxation, the secured claim of the Internal Revenue Service, and a 5% dividend on unsecured claims.
It is evident that the driving force behind the behind the debtor's chapter 13 filing was the need to address and pay off his state and federal taxes. On September 10, 1998, the IRS filed a timely proof of claim (Claim No. 3) in the amount of $138,064.10, of which $47,103.00 is asserted as a secured claim, $68,692.14 as a priority unsecured claim, and $22,268.96 as a general unsecured claim. The debtor subsequently filed an objection to the amount of the secured claim. After the court ruled on one aspect of that objection, In re Leedy, 230 B.R. 678 (Bankr. E.D. Va. 1999), the parties reached a settlement which resulted in the IRS filing an amended proof of claim (Claim No. 11) on March 29, 1999, asserting a fully secured claim in the amount of $138,064.10.
The debtor filed the present adversary proceeding under § 505, Bankruptcy Code, to determine the amount of his tax liability for the years 1991 and 1992. The complaint challenges the IRS's final assessment of tax deficiencies for each year, whereby the IRS, following an audit, determined that the debtor had improperly deducted $85,300 in expenses on Schedule C of his individual income tax return. The disputed expenses were incurred by the debtor in connection with the business of two corporations he had formed. It is the IRS's position that the expenses are attributable to the corporations for tax purposes and could have been deducted, if at all, only by the corporations.
Section 505, Bankruptcy Code, provides in relevant part as follows:
(a)(1) Except as provided in paragraph (2) of this subsection, the court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed, whether or not paid, and whether or not contested before and adjudicated by a judicial or administrative tribunal of competent jurisdiction.
The disallowed amounts were $41,896 for 1991 and $43,404 for 1992. As a result, the IRS issued notices of deficiency for both those years on December 30, 1994, asserting a total deficiency of $35,913 ($15,678 for 1991 and $20,235 for 1992). On May 16, 1996, the debtor filed amended returns for both years, claiming a refund of $13,499 for 1991 and no additional tax due for 1992. Apparently the IRS declined to process the amended returns. In his brief, the debtor asserts that a ruling in his favor would reduce the total deficiency for 1991 and 1992 to $3,129, plus late payment and late fling penalties. He further asserts that because he subsequently made payments of $10,088 that were applied to the 1992 deficiency, he would actually be due a modest refund. The IRS disputes the debtor's computation.
After retiring from the military in 1990, the debtor formed seven corporations in the period from 1991 to 1996 as vehicles for the business of distributing goods. Two of these — Monarch Trading Company ("Monarch") and Donnelly Leedy, Inc. ("Donnelly Leedy") — are relevant to the present dispute. Formed in 1991 and partially funded by a third-party investor, Monarch was to engage in the trading of surplus commodities and military excess. Similarly, Donnelly Leedy, incorporated in the state of Georgia, was founded by the debtor and a colleague in late 1991 to negotiate specific transactions in the international trade arena. The debtor's primary reason for conducting business in the corporate form was in order to obtain export licensing and to attract interest from potential clients. As it turned out, both companies flopped for failure to generate any revenue. Monarch was in existence for only a few months in 1991, while Donnelly Leedy ceased its operation and dissolved in late 1992. As the corporations struggled to survived, the debtor took it upon himself to pay the bills of the corporations through checks drawn on his personal bank account. The complaint, relying on § 162 of the Internal Revenue Code, 26 U.S.C. § 162, asserts that the debtor is entitled to deduct those amounts as ordinary and necessary business expenses incurred by him in the course of establishing and administering the businesses conducted by the corporations.
The record does not reflect whether Monarch has ever been formally dissolved.
It appears that neither corporation had a bank account of its own.
Section 162(a) of the Internal Revenue Code provides in part: "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business . . ."
Discussion I.
Under Federal Rule of Bankruptcy Procedure 7056, which incorporates Rule 56(c), Federal Rules of Civil Procedure, summary judgment is appropriate "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." In ruling on a motion for summary judgment, a court should believe the evidence of the non-movant, and all justifiable inferences must be drawn in his favor. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986). At the same time, the Supreme Court has instructed that summary judgment "is properly regarded not as a disfavored procedural shortcut, but rather as an integral part of the Federal Rules as a whole, which are designed `to secure the just, speedy and inexpensive determination of every action.'" Celotex Corp. v. Catrett, 477 U.S. 317, 327, 106 S.Ct. 2548, 2555, 91 L.Ed.2d 265 (1985).
II.
Unlike a sole proprietorship or partnership, the corporate form of conducting business serves to protect its principals and investors by limiting their liability to creditors, since for most purposes a corporation is treated as an entity separate and distinct from its shareholders and directors. This recognition of the corporation as a distinct entity extends, with some exceptions (most notably, so-called "S" corporations) into the realm of taxation. The issue presented is whether a taxpayer whose newly-formed business corporation never quite gets off the ground may deduct corporate business expenses that the taxpayer paid on the corporation's behalf. Since the corporations here had no significant revenues, the deductions would provide little or no benefit if only the corporations could take them. The IRS nevertheless argues that if an individual taxpayer voluntarily creates a corporation to suit his or her own purpose, the taxpayer may not thereafter disregard the corporate entity in order to claim an otherwise unavailable tax benefit.
The IRS relies principally on the landmark case of Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 63 S.Ct. 1132, 87 L.Ed. 1499 (1943) as setting forth the legal standard for when the tax incidents of a transaction would fall on the corporation rather than the individual or individuals behind the corporation. In Moline, an individual conveyed real property (apparently at the suggestion of a mortgage holder) to a corporation that the individual founded and owned. When the real estate was eventually sold at a profit, the corporation ceased to transact any business but was not formally dissolved. The question before the Supreme Court was whether the gain realized on the sale was taxable to the corporation or its founder. The Court, in ruling that the gain was taxable to the corporation, held that a corporation will not be disregarded for federal tax purposes if it was formed with a business purpose or engaged in business activity. 319 U.S at 439, 63 S.Ct. at 1134 ("so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation"). The exception recognized by the Court is where the corporation is a "sham or unreal." Id.
The principal announced in Moline is simple enough to state, but, like many rules of law, strongly dependant upon the facts of a particular case. As a result, courts are constantly faced with the challenge of drawing the line of when a particular corporation should be recognized as a separate taxable entity. As one court ruefully observed, "The difficulty lies in the fact that we are constantly confronted with apparently distinguishable situations." Britt v. United States, 431 F.2d 227, 232 (5th Cir. 1970). Such a reality is exemplified in the case at hand. Nevertheless, the court believes that the evidence supports the IRS's position that the expenses in question could only be deducted by the corporations.
Looking to the first prong of the Moline Properties test, it is undisputed that Monarch and Donnelly Leedy served a business purpose. In his deposition, the debtor clearly testified that the corporations were formed to engage in the trading of commodities. PL Ex. F at 10-11. The debtor believed that the corporate format was the best way of attracting business and clients in the trading arena. According to the debtor, "a sole proprietorship or a self-employed situation would not attract any interest from people who have their own agendas with respect to international trade." Id. at 24. Moreover, the debtor explained in his deposition that the corporations were necessary to obtain export licensing. Id. The debtor provided many other reasons for operating Monarch and Donnelly Leedy, but the submitted evidence is devoid of any suggestion that the corporations had no business purpose. The debtor freely admitted in his deposition, "For me to represent either [corporation] as sole proprietorship would have been dishonest at best and probably fraudulent . . ." Id. at 47.
In addition, the business purpose behind the formation of the corporations was followed by the carrying on of business activity. Although neither corporation was successful, failure to thrive does not equate to not engaging in any business activity. The clearest example was the corporations' attempt to become an exclusive distributor of collector knives in Germany. Although the market never materialized, the corporations sent and received correspondence in connection with the distribution of these knives. Def. Ex. 2C and 2D. In fact, Donnelly Leedy purchased a sample of knives to be marketed in the region. PL Ex. E at 39. Another instance of business activity was the entry into a compensation agreement between Donnelly Leedy and another corporation for the purpose of reselling commodities. Def. Ex. 2G.
In support of his motion for summary judgment, the debtor argues that Moline and other cases cited by the IRS are factually distinguishable. The key distinction, according to the debtor, is that Monarch and Donnelly Leedy never held title to any property. Furthermore, the debtor points to the facts that neither corporation maintained books and bank accounts, held shareholder meetings, or earned any revenue. Citing to a line of cases, the debtor also argues that the corporations never transacted a significant amount of business. See Blue Flame Gas Co. v. Commissioner, 54 T.C. 584 (1970); Bystry v. United States, 596 F. Supp. 574 (W.D. Wis. 1984); Woods Lumber Co. v. Commissioner, 44 B.T.A. 88 (1941); Barker v. Commissioner, 1993 WL 231735, T.C. Memo 1993-280(1993).
In considering a motion for summary judgment, the court of course must draw all justifiable inferences in the favor of the non-moving party. It is true that Monarch and Donnelly Leedy are not shown to have held title to any assets and had no money under their names in a commercial bank account. However, the reason for the lack of assets is that the corporations were unsuccessful in generating business. Because the corporations had no clients, there was no need to for them to own commodities for distribution. As for the money and bank accounts, the debtor made the point in his deposition that the reason he used a personal bank account, instead of setting up separate commercial accounts, was because the opening of a commercial account required a larger initial deposit than he could afford. The record here clearly reflects that the debtor held the corporations out to the public as conducting business. Although Monarch and Donnelly Leedy may not have observed all of the required corporate formalities, at no time did the debtor treat or regard them as shams.
As noted, the debtor argues that Monarch and Donnelly Leedy did not engage in a "significant" amount of business activity. The government, however, citing to Britt v. United States, 431 F.2d 227, 235 (5th Cir. 1970), contends that the determination of whether a corporation is considered to be conducting business is not dependent upon the "quantum of business." The court sides with the IRS and finds Britt to be persuasive. To hold otherwise ignores the decision in Moline Properties, since the corporation in that case conducted no business other than holding title to real property. 319 U.S. at 437, 63 S.Ct. at 1133. Presented with those facts, the Supreme Court never hinted that the limited scope of the corporation's business activity precluded its recognition for tax purposes. The cases cited by the debtor are not to the contrary and do not hold that a corporation's business activity must be "significant" or "substantial" before it will be recognized as a separate taxable entity. See Blue Flame, 54 T.C. at 600 ("[T]he business operations in question were sufficiently disjoint from the corporation originally formed[.]"); Barker, 1993 WL 231735 at *3 ("The question is not whether petitioner is seeking to evade Moline Properties, but whether the corporate activity was sufficient to fall within it[.]"). Even if the debtor is correct that there is some threshold amount of business activity that must be conducted before the corporation will be recognized for tax purposes, there is ample evidence showing that the corporations here engaged in significant business activity in the form of marketing efforts, even though those efforts did not come to fruition in the form of either revenues or profits.
In his argument, the debtor focuses on his purpose in paying the corporations' expenses and contends that the deductions are warranted since the expenses related to the setting up and management of the corporations. The debtor points to case law that has permitted entrepreneurs or corporate managers a deduction for corporate expenses individually incurred by them. See Commissioner v. Stokes' Estate, 200 F.2d 637 (3rd Cir. 1953); Giblin v. Commissioner, 227 F.2d 692 (5th Cir. 1955); J. T. Dorminey v. Commissioner, 26 T.C. 940 (1956). Put another way, the debtor argues that he incurred the expenses in furtherance of his personal business of trading goods. The case of Stokes' Estate exemplifies the plaintiff's argument. There, the individual taxpayer financed several corporations, in which he was active, to further develop his patents. When the loans were not repaid, the taxpayer sought to deduct them as bad debts incurred in his trade or business. Finding that the individual was more than a mere investor in the companies, the court ruled that the loans he extended were the result of the debtor engaging individually in the business of exploiting patents by financing and actively participating in the management of corporations. 200 F.2d at 638.
The court cannot find from the record that the debtor's business was the financing of start-up corporations. It is true that since retiring from the military, the debtor has formed a number of corporations the purpose of which was to engage in the sale and distribution of commodities. However, the debtor has not demonstrated that he was individually engaged in that business. He testified in his deposition that he never operated as a sole proprietor. The debtor has chosen a career of distributing goods, but that alone does not amount to a trade or business. The debtor was evidently nothing more than an active shareholder in his business. Betson v. Commissioner, 802 F.2d 365, 368 (9th Cir. 1986) ("As a general rule, the trade or business of a corporation is not that of its shareholder"). Disapproving a line of cases, including Stokes' Estate, the Supreme Court in Whipple v. Commissioner, 373 U.S. 193, 203, 83 S.C.t. 1168, 1174, 10 L.Ed.2d 288 (1963) held: "Absent substantial additional evidence, furnishing management and other services to corporations for a reward not different from that flowing to an investor in those corporations is not a trade or business[.]" (footnote omitted).
The debtor here has failed to present any evidence that would allow a trier of fact to find that the payments in question were made for any purpose other than to benefit Monarch and Donnelly Leedy. A common-sense view of the facts leads the court to conclude that the debtor's motivation in paying the expenses of Monarch and Donnelly Leedy was to keep them afloat in the hope that they would generate income in the future. See Deputy v. Du Pont, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 416 (looking to the origin of the payments); Dodd v. Commissioner, 298 F.2d 570, 576 (4th Cir. 1962) (advanced funds were for the benefit of and to the continuing existence of the corporation).
III.
Although the complaint relies exclusively on § 162, Internal Revenue Code, the debtor's motion for summary judgment raises for the first time additional grounds for allowance of the deductions. First, the debtor contends that the expenses constitute "start up" expenditures under § 195, Internal Revenue Code, which may be amortized over a period of 60 months and may be deducted by him as an ordinary loss under § 165, Internal Revenue Code in the year the corporations ceased business. Second, the debtor suggests that he is entitled to an ordinary loss deduction under § 1244, Internal Revenue Code. Finally, the debtor argues that if the payments are treated as loans, they are deductible as a bad debt under § 166, Internal Revenue Code, in the year the corporations ceased to function.
Generally, when stock becomes worthless, an individual may deduct such loss as a capital loss under § 165(g), Internal Revenue Code, subject to the limitations of § 1211, Internal Revenue Code. An exception to this rule is available under § 1244, Internal Revenue Code, which allows the loss on a qualified stock to be treated as an ordinary loss. See Clayten v. United States, 448 F. Supp. 30 (D. Md. 1977); Pecora v. Commissioner, 1998 WL 774655, T.C. Memo 1998-393 (1998).
The government, while denying that any of the additional grounds are applicable, has not objected to their consideration, even though the complaint is devoid of any factual or legal allegation that would implicate any statutory ground for deduction other than Section 162. The problem here, however, is two-fold: first, the debtor has never filed a return claiming the deductions under the theories now advanced; and second, nothing in the summary judgment record expressly supports these alternate theories.
Rule 8(a), Fed.R.Civ.P., which is incorporated by F.R.Bankr.P. 7008, provides that a complaint is sufficient if it contains a "short and plain statement of the claim showing that the pleader is entitled to relief." The purpose is to give the opposing party fair notice of what the claim is and the grounds upon which it rests. Conley v. Gibson, 355 U.S. 41, 47, 78 S.Ct. 99, 103, 2 L.Ed.2d 80 (1957). Although a complaint is not required to set forth all the facts underlying the claim, the debtor's complaint, by specifically citing only to Section 162, Internal Revenue Code, arguably fails to impart fair notice that the debtor would seek to deduct the payments on alternative grounds. Nevertheless, since the government has responded to the merits of the debtor's arguments and has not objected that they are outside the scope of the issues raised by the pleadings, the court will consider them. See Rule 15(b), Fed.R.Civ.P. ("When issues not raised by the pleadings are tried by express or implied consent of the parties, they shall be treated in all respects as if they had been raised in the pleadings.").
The court agrees with the IRS that characterizing the deductions as "start-up" expenses under § 195 rather than business expenses under § 162 does not change the analysis. Regardless of how the payments are characterized, the right to deduct them belongs to the corporation, not to the debtor individually. Additionally, the election to amortize rather than capitalize such expenses must be made not later than the date the return is due for the year in which the expenses were incurred. 26 U.S.C. § 195(d). That date has long since come and gone. With respect to § 165, the debtor argues that since no stock or other securities were ever issued by the corporations, and since the corporate formalities were never observed, the debtor's losses should be treated as ordinary losses. The problem with this argument is that it ignores the debtor's deposition testimony wherein he testified, for example, "I contend that that [sic] splitting of hairs as to whether it's a capital investment or business expenses." PL Ex. E at 23. Such an acknowledgment precludes a determination that the debtor incurred an ordinary loss, since it appears that the debtor was acting as though he was a shareholder of the corporations with the hope that the corporations would turn around. Although no stock was ever issued to the debtor, the debtor may have had a right to receive shares in the corporations within the meaning of § 165(g)(2). See Schuerhok v. Commissoner, 1976 WL 3357 at *4, T.C. Memo 1976-163 (1976) (holding that taxpayer had a right to receive stock in exchange for an investment in a corporation despite the absence of corporate meetings and the failure of the corporation to issue stocks). The debtor's position that the expenses could be treated as a loss on small business stock under § 1244, while it has some minimal support in the above-quoted deposition testimony, nevertheless fails because the amount of the loss that may be deducted under that provision cannot exceed the amount of the corporation's gross income during the five year period before the loss on the stock was sustained. 26 U.S.C. § 1244(c)(2)(C). Furthermore, the deduction is limited to the debtor's initial investment in the corporation for the purchase of the stock. Zuravin v. United States, 1996 WL 529317 at *3 (D.Md. 1996). Assuming that "Section 1244" stock was purchased by the debtor, the record does not reflect that the basis (or purchase price) amounted to $85,300. Finally, the debtor is not entitled to a "bad debt" deduction under § 166 for a loan that became worthless. When determining whether an advancement is a loan, the court must look to the substance of the transaction, not the form in which it was cast. Road Materials, Inc. v. Commissioner, 407 F.2d 1121, 1124 (4th Cir. 1968). For purposes of summary judgment, the debtor, nevertheless, has failed on either front. The IRS is correct in stressing that there is no evidence before the court that points to a debtor-creditor relationship between the debtor and the corporations. For example, the debtor has not submitted any promissory notes, let alone any terms of repayment, or records that reflect that the monies advanced by the debtor were loans to the corporations. See Dodd, 298 F.2d at 578.
The debtor offered no evidence of any documentation that any particular price had been set for issuance of shares, and no evidence that the expenses paid by him were recorded on the corporation's books as payment for the shares.
A separate order will be entered granting summary judgment to the IRS and dismissing the complaint.